The Main Problem in Using Stocks for Income Investing

Picture Credit: Quinn Dombrowski || Today we’re going to play the “tiny game.” How about a T-bill? Oh, you won, you showed me the interest on your checking account…

This article arises out of two articles that I’ve read in Barron’s over the past 3 months. One was in early January, and it was the front page article on income investing. The other was the front page article for this past week, and it was on dividend paying common stocks as a means to finance your retirement.

With the first article on income investing, the main point I was going to make is that risky bonds and other investments that carry high yields usually embed some sort of equity risk. In a scenario where the credit cycle goes bearish, those risky investments will be as risky as common stocks for the duration of the bear market.

Remember that the time to buy risky assets is when most other people and you are scared to death in the midst of a bear market.  Or, wait until the price cuts above the 50-day moving average.  Don’t be a yield hog when market valuations are so extended.

But for the article in this week’s Barron’s, my point is a different one.  Many people have gotten too comfortable with the concept of using dividend paying common stocks for income in retirement portfolios. The first thing you have to remember about dividend paying common stocks is that they are stocks. Over short horizons they carry considerable risk of loss of principal.

What does that imply for the investor that wants to pursue such a strategy? It means that he must have a long enough time horizon and a diversified portfolio that has some safe assets in it. This allows the investor to be able to ride out a temporary decline in the market, together with any dividend cuts that you might face in a bearish market environment.  The safe assets can be tapped to provide emergency spending money, or used to buy cheap dividend paying stocks amid the carnage.

Now, you can mitigate some of these risks by buying high quality dividend paying common stocks. Note: you will have to give up some income to do this. Those stocks have adequate coverage for the dividend and adequate ability to reinvest in their business. They sport reasonable prices relative to their earnings potential.

You can also mitigate the risk even though it does not pay much yield at present by owning a ladder of bonds or bond funds with high credit quality.  Remember that laddering is consistently the second best strategy with respect to interest rate risk.  Being good at forecasting is the best strategy, but who can be so good?

If you do it this way, which is similar to the income strategy that I do for older folks, you will never get thrown out of the game via panic. In my investing, I never go below 60/40 stocks/bonds, and I never go above 80/20 stocks/bonds. Right now I’m at 65/35, and I’m thinking about going to 60/40.

Even though I think the market on the whole is overvalued, there are many niches in the market that are not. There are areas with stocks that have a reasonable price earnings multiple, accompanied by a reasonable dividend. That said you won’t be in the part of the market that has been popular for the last several years. Few people want to take the path that has underperformed in the recent past.

To summarize: if you have so much assets that the yields on your dividend portfolio will never provide less income than what you need, great, go ahead and invest solely in dividend paying common stocks. But if you want to avoid the panic in the bear markets and perhaps take a little bit less in return but still do well over the long haul, do what I do: run a portfolio that’s a balanced fund where the stocks pay dividends. With a portfolio like that you won’t win awards in a bull market but you will feel very comfortable in a bear market and not be scared or pressured to sell at a bad time.